Wednesday, March 31, 2010

Jeff Hummel has a post on Liberty and Power about proposals to break up the big banks. He points out that some "market-oriented" economists have supported this proposal as a way of avoiding "too big to fail."

Hummel points out that the U.S. banking industry is very fragmented, with many more banks than typical in industrialized countries. He points out that restrictions on bank branching, dating to before the Civil War, have been responsible for the huge number of tiny banks in the U.S. And further, that these regulations are responsible for the record number of bank panics in the U.S.

This argument is very traditional for advocates of free banking, and it is one that I have made often in the past, and one that I still consider sound. Most of the 8,012 depository institutions in the U.S. should be taken over by much smaller number of nationally-branched banks. How many exactly and what market share each should have is something that can only be discovered by the competitive market process--a process without regulations aimed at protecting small community banks.

Given that caveat, I have always had a vision of 20 nationally-branched banks with market shares averaging 5 percent, running between 10 percent and 2 percent. So, given the current size of the banking industry, that would be an industry made up of large banks with assets of between one and two trillion and small banks with assets between $100 and $200 billion. Looking at the top bank holding companies, number one Bank of America, whose holding company has $2.2 trillion in assets, and number 4, Wells Fargo, with $1.8 trillion, are on the big side. A bank like BB&T, at number 17, with assets of $166 billion, is getting on the small side.

The problem with the 7,340 "small" banks, with assets less than $1 billion is lack of geographic diversification. Why have such banks have prospered, even after branching restrictions have been removed? One reason is moral hazard. Depositors have no reason to worry about geographic diversification if they are insured by FDIC.

Worse, one aspect of loan securitization has been that banks and thrifts make local loans, sell them to investment banks who pool them across geographic regions, and then create asset backed securities, some of which are are then sold back to the banks and thrifts that originated the loans. The process does allow community banks to reduce their local risk exposure, but at the expense of a complete loss of control of credit risk. A nationally-branched bank would automatically avoid idiosyncratic geographic risks without any need for convoluted asset-backed securities.

Another element of the banking system that evolved in the U.S. is that some the banks whose "locality" was Wall Street became giant "money center banks." Chase Manhattan, which merged with investment bank J.P. Morgan, is now number 2, with $2 trillion in assets. Citibank is number 3 with $1.85 trillion in assets. These banks don't have branches across the nation. Traditionally, they have obtained huge amounts of "brokered" deposits and made large loans. At least some of that funding comes from the thousands of small banks.

This is one element of systematic risk that has been long standing. A money center bank fails, and all of the small community banks that lent it money suffer losses too. If the losses are severe enough, they can fail. And problems can occur in the other direction. If enough small community banks have difficulties--either depositors withdrawing funds or bad loans, then they will cease lending money to the money center bank. If that endangers the money center bank, then other community banks are at risk.

To confuse matters, there are the "investment banks" Are banks "too large?" Are they "too big to fail?" Often the "banks" being discussed are investment banks, such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Bears and Stern, and Lehman Brothers. While Goldman Sachs currently has assets of "only" $850 billion, it had $1.1 trillion at the end of 2007. Similarly, Morgan Stanley is down to $775 billion, but had over $1 trillion at the end of 2007. Merrill Lynch also had more than $1 trillion. These were very large institutions: only Citibank, Bank of America, and JP Morgan Chase were larger in 2007. Further, their total size was 20 percent of the size of the commercial banking industry.

The core business of an investment bank is underwriting securities. The people responsible for organizing "deals" with governments and large firms needing to raise money are called "bankers." However, the firms also serve as broker-dealers, and the people who arrange trades of securities--stocks and bonds--are called "traders."

Governments and large corporations interested in obtaining large amounts of money can go to a commercial bank, presumably a money center bank like Citibank or Chase Manhattan, and obtain a loan. Or, they can speak to a "banker" at an investment "bank" like Goldman Sachs. The investment bank will help them issue bonds or stocks. Since these are just different ways of raising money on Wall Street, they are all "banks" from the point of view of major corporations or governments that need the funds.

What is different, of course, is that these "investment banks" don't have deposits. When they underwrite securities, they are immediately funding the governments or businesses, but as the securities are sold, then the investors who purchase those securities provide the funding to the particular government of business issuing the bonds or stocks.

The broker-dealer operations of these "banks" involve trading stocks and bonds. Since underwriting securities involves selling newly issued stocks and bonds, there is an obvious synergy between the two branches of the business. The "bankers" make deals with governments and businesses that need funds, and the "traders" find investors who are interested in purchasing the bonds and stocks that are issued by the governments or firms.

Broker-dealers trade huge volumes of stocks and bonds, often with large institutional investors and hedge funds. Selling the stocks and bonds underwritten by their own "bankers" is only a small part of their business.

Because of clearing arrangements, the traders can and do buy securities with money they don't have and sell securities they don't have. They just have to come up with sufficient money or securities to meet clearing obligations. In order to make large and rapid trades, their counter-parties must have confidence that they will be able to obtain sufficient money or securities to meet clearing obligations. If, say, Morgan Stanley is not confident that Lehman Brothers will be able to deliver funds or securities as promised at clearing time, then it won't trade with them. If Lehman Brothers cannot trade with the other broker-dealers, then it won't be able to do business with institutional investors and hedge funds. Lehman Brother's broker-dealer business will dry up and it will be ruined.

There is substantial "systemic" risk involved. Suppose a hedge fund sells some stock to Lehman brothers and then uses the funds to purchase some bonds from Merrill Lynch. And then Merrill Lynch buys some other stock from Bear Stearns. If Lehman Brothers can't come up with the funds at clearing time, then the hedge fund doesn't have the money. And Merrill Lynch doesn't have the money for the bonds it sold to the hedge fund. And Bear Stearns doesn't have the money for the stock it sold to Merrill Lynch. Since hedge funds, especially, need to make large, timely trades, having these markets "freeze" is a "disaster." Well, a disaster to hedge funds. For institutional and individual investors following a sensible buy and hold strategy, it means modest delays in obtaining needed funds.

As part of the process of underwriting securities, investment banks have always borrowed short term funds. They pay out the borrowed funds to the firms and governments whose securities they are underwriting and then as their traders sell off those securities, the borrowed funds can be repaid. Of course, since they try to operate as continuing businesses, the investment banks are borrowing short term funds all the time.

Similarly, the broker-dealer operations borrow short term to obtain funds to meet clearing demands. (And they borrow securities as well.)

Over the last decade, these investment banks began to hold large portfolios of mortgage backed securities. So, just as some community banks were using their deposits to fund "safe" geographically-diversified mortgage backed securities, the Wall Street banks were using short term funding to finance holdings of mortgage backed securities.

So, along with underwriting securities and operating as broker-dealers, they were operating as commercial banks. But because the financial commercial paper they used for funding is not called "deposits," they weren't legally operating as commercial banks. They were "shadow banks."

When home prices began falling, ultimately by 30 percent, mortgage backed securities lost value. The newish "shadow bank" side of the "investment banking" business lost money. Since the broker-dealer side of the business requires trust by counter-parties, especially other broker-dealers, these losses from the shadow bank operations threatened to put the broker-dealer operation out of business. And a failure by a major broker-dealer would create "systemic risk" because those who did trade with them and then trade with securities or funds that had yet to be delivered would not be able to complete trades they had made based upon money or securities that had not been delivered.

Meanwhile, Citibank, currently number 3, but at the height of its folly, the largest commercial bank in terms of assets, was using large amounts of brokered deposits to fund portfolios of mortgage backed securities, often organized as "Structured Investment Vehicles." It was undertaking the same activity as the "shadow bank" operations of the investment banks.

Citibank didn't count the assets or liabilities of the SIVs on its balance sheet. If Citibank's risk was limited to its investment in the SIV, then that would have been reasonable. What that would mean is that when the mortgage backed securities lost value, the investors in the SIV would take most of the loss. Incredibly, when the mortgage backed securities lost value and the investors in the SIVs demanded payment, Citibank lent the money need to cover withdrawals and took all the assets. In other words, all of Citibank's capital was at risk!

At the end of 2007, Citibank had $2 trillion in assets. That was about 15 percent of the commercial banking industry and 10 percent of all financial firms (including investment banks and insurance companies.) I believe that the key to Citibank's survival was hiring Robert Rubin, former Secretary of Treasury of the Clinton administration, who happened to have been, along with Larry Summers, the mentor of Tim Geithner, President of the New York Fed during the crisis and now Secretary of the Treasury in the Obama administration. Today, it is down to number 3, but it was "bailed out." All of those who provided the uninsured brokered deposits to fund Citibank avoided losses. As did those who invested in the SIVs. (In my opinion, there should be some Citibank executives in jail. SIVs are fine if the investors take a loss. If Citibank brings them back on its balance sheet, it was a fraud against those holding brokered deposits issued by Citibank proper, as well as FDIC who must cover any losses on insured deposits.)

JP Morgan Chase combined an investment bank, JP Morgan, more or less like Goldman Sachs, with a money center bank, Chase Manhattan, more or less like Citibank. It was number 3, at $1.5 trillion in 2007 and is now number 2 with $2 trillion. While it took its "bailout" like the rest, it did not make the errors of the stand alone investment banks or the other money center commercial bank, Citibank.

Bank of America was a large, nationally branched commercial bank. In 2007, it was number 2, with $1.7 trillion. In early 2008, it purchased Countrywide, a thrift that had lent heavily into the speculative bubble in housing. While Countrywide only had $211 billion in assets, it was servicing $1.9 trillion in mortgages. In late 2008, Bank of America purchased Merrill Lynch, which had over a $1 trillion in assets in 2007. Whatever problems Bank of America already had with real estate loans and mortgage backed securities, it spent 2008 adding to its problems. Of course, it is now number one with $2.2 trillion in assets.

Wachovia was the 4th largest commercial bank in 2007 and the 9th largest financial institution. It was nationally (or, at least, regionally) branched. It had $782 billion in assets, and so was well behind investment banks like Goldman Sachs, Morgan Stanley and Merrill Lynch, money center banks Citibank and JP Morgan Chase, and Bank of America, the other nationally-branched commercial bank. In 2006, it purchased Gold West, a thrift with $125 billion in assets which included plenty of bad mortgage loans. As those bad loans sank Wachovia, the government tried to merge it with Citibank. (This would have given a financial disaster, Citibank, a national branch network. The broke would be merged with the broke, but would create an excuse to funnel money to politically connected Citibank.) However, Wells Fargo, with $575 billion in assets in 2007, purchased Wachovia instead. Wells Fargo, now including Wachovia (and Gold West,) is a nationally branched commercial bank,with $1.8 trillion in assets.

And what of the investment "banks" that, along with money center commercial bank, Citibank, were at the center of the crisis? Goldman Sachs and Morgan Stanley are now bank holding companies. They are now like JP Morgan Chase. Bear Stearns is owned by JP Morgan Chase. Merrill Lynch is owned by Bank of America. And the broker-dealer operations of Lehman Brothers is now owned by Barclays North America, which is owned by Barclays, a British bank holding company.

Are these institutions too big? Are they too big to fail? Wachovia failed. While it wasn't the biggest, it was of the same order of magnitude as these institutions. Citibank undertook what was borderline criminal activity. Was it too big to fail? Perhaps it is too late now, but I don't see why FDIC couldn't have taken it over, maybe even clawed back some of the SIV funds, guaranteed whatever brokered deposits it wanted, and then reorganized the bank.

The investment banks didn't fail because of underwriting losses or bad trades. They operated what amounted to commercial banks--borrowing with short term commercial paper and funding large portfolios of mortgage backed securities. They simply made what amounted to bad loans. Nothing in this experience suggests that the merger of J P Morgan and Chase Manhattan creates some kind of danger to Chase Manhattan. The actual lesson would be that if Chase Manhattan made too many bad loans and fails, this might make it impossible for traders at JP Morgan to transact stocks and bonds because counter-parties would worry about deliveries of funds and securities at the clearinghouse!

The nationally (or at least, regionally) branched commercial bank that failed, Wachovia, didn't fail because it was too big, or took losses on underwriting loans, or had trading losses. It failed because of bad loans, though bad loans from a recently purchased subsidiary.

My view is that nothing in the current crisis shows that large nationally-branched universal banks that accept deposits, make loans, underwrite securities, and trade securities are a danger. There really weren't any universal banks in the U.S. going into the crisis. Today, Bank of America fits that model. Rather than breaking Bank of America up or shrinking it, the best solution is for there to be more such institutions, and that perhaps they will grow more quickly than Bank of America, resulting in less concentrated banking system--about 20 universal banks with roughly 5 percent market shares.

The trivial lesson from the crisis is that banks shouldn't make bad loans. Don't lend into a speculative bubble! Since so many banks and thrifts (including the shadow bank operations of the investment banks,) did make similar mistakes, the key lesson I take from the crisis is that the possibility of a large portion of the banking system simultaneously becoming bankrupt must be considered.

And, of course, making sure that the quantity of money (however defined) always adjusts enough so that cash expenditure is expected to return to an unchanged 3 percent growth path within the next year will greatly reduce any real disruption created by the failures of banks, whether investment, commercial, money center, community, or nationally-branched or universal.

The fundamental principle of macroeconomics is the same as the fundamental principle of microeconomics--scarcity.

A general glut, an output gap, and involuntary unemployment are interesting and important because of scarcity. Many macroeconomic fallacies result from the false notion that the key economic issue is finding things for people to do rather than effectively allocating resources to produce what people want most. The disruptions caused by monetary disequilibrium are problems because they interfere with the market processes that embody the most effective social response to scarcity.

Frederic Bastiat did a great job in exploding fallacies and explaining how scarcity is really the fundamental economic issue.

Sunday, March 28, 2010

Final Sales for Domestic Product for the fourth quarter of 2009 was again revised downward. The first estimate was $14,503 billion. It was revised downward to $14,482 billion. The final figure is $14,477 billion. It grew at an annual rate of only 2.2 percent since the third quarter of 2009.

It is 10.5 percent below the long run 5.4 percent growth path. It is 7.5 percent below the modified 3 percent growth path I favor.

My preferred target for the first quarter of 2011 is unchanged by the revisions. It remains $16,202 billion. (The second quarter target is $16,324 billion.)

Between the fourth quarter of 2009 and the first quarter of 2011, nominal expenditure needs to increase by 11.2 percent, which is a 9 percent annual rate of growth.

Wednesday, March 24, 2010

Many economists blame the Great Recession on a credit boom instigated by the Federal Reserve in 2001-2004. John Taylor blames a failure by the Fed to follow the rule that bears his name. The Fed's target for the federal funds rate was left too low for too long. San Francisco Fed President Janet Yellen claims that higher interest rates would have slowed housing appreciation and restrained excessive credit creation in securitized markets.

"Austrian" economists sometimes take comfort in these arguments, seeing them as at least partial acceptance of their long standing view about recessions being the aftermath of a credit boom generated by a central bank. In their view, the expansion of the quantity of money by the Fed caused interest rates to fall too low, which resulted in a vast expansion in spending on new single family homes. Rising prices and production in this sector were unsustainable, and resulted in the recession. David Beckworth, of Macro and Other Market Musings, appears to take this approach.

That interest rates were remarkably low during part of the "naughties" is certainly true.

During 2001, the Fed cut the federal funds rate 4.75 percentage points, from 6.5 percent in late 2000 to 1.75 percent in early 2002. After a pause, the reductions continued, hitting a low of 1 percent in mid 2003. The remarkably low level of the federal funds rate was continued until mid-2004. At that point, interest rates began a long series of regular increases.

However, showing that some price is lower (or higher) than usual, hardly proves that it is too low or too high. The role of prices in a market economy is to coordinate the decisions of market participants and changing conditions may require large changes in prices. So, were interest rates "too low" from late 2000 until sometime in 2005 or after?

I believe that the least bad policy for the Fed is to keep nominal expenditure on a slow, steady growth path. Ideally, I favor a 3 percent growth path, which is consistent with a stable price level on average.

However, the Fed aimed at 2 percent inflation, which implies more rapid growth in nominal expenditure. Looking at the actual growth path of nominal expenditure during the Great Moderation (dated from first quarter 1984 until the third quarter of 2008,) its trend growth rate was 5.4 percent. However, there were substantial deviations of nominal expenditures around that growth path. The diagram below shows Final Sales of Domestic Product from 1984 through the end of 2009.

The Great Moderation can best be characterized by nominal expenditure remaining very close to its trend growth path. Of course, the most striking aspect of the diagram is the catastrophic decrease in nominal expediture in the fourth quarter of 2008. While the Great Recession is officially dated as beginning at the end of 2007, the mild reduction in spending growth was "normal" for the Great Moderation until disaster struck a year later.

Other milder deviations include nominal expenditure being above its trend growth path in the late eighties and the late nineties. Of course, the deviation most relevant is during the supposed credit boom--nominal Final Sales of Domestic Product was below its trend growth path during that period. The following diagram shows Final Sales of Domestic Product from 1998 until 2006.

Total final sales fell below trend in the first quarter of 2002. It has remained below trend ever since, but by the second quarter of 2005 and up through the first quarter of 2008, the shortfall remained less than 1 percent. So, there was a shortfall of nominal expenditure from trend of more than 1 percent from the second quarter of 2002 until the first quarter of 2005. The largest shortfall was in the first quarter of 2003--2.6 percent.

The Fed began its rapid cuts in the federal funds rate in late 2000, while nominal expenditure remained well above trend. The rapid decrease had already occurred when nominal expenditure fell below trend. And the further decreases to 1.5 percent and then to 1 percent occurred while nominal expenditure was approximately 2 percent below its long run growth path.

If the goal of the Fed were to keep nominal expenditure on a stable growth path, (and it should be) and a decrease in the federal funds rate is the method by which the Fed expands nominal expenditure (which is plausible,) then the decreases in the federal funds rate were appropriate.

There are economists who accept the goal of stable nominal expenditure, but claim that the Fed's policy was "too expansionary." Larry White made this argument, as has David Beckworth. They focus on the growth rate of nominal expenditure. The following is the growth rate of Final Sales of Domestic Product from 1998 until 2006.

The growth rate of nominal expenditures fell below its trend growth rate of 5.4 percent in the third quarter of 2000. And soon after, the Fed began the long and rapid reduction in the federal funds rate. In 2003, the growth rate of nominal expenditure rose close to its the trend growth rate of 5.4%.

While first quarter growth was a bit below trend, second quarter growth was very close. The third quarter of 2003 had a remarkable 8.6 percent growth rate. But perhaps more troubling than that one remarkable quarter is the trend of accelerating growth starting mid 2004 and continuing through 2005.

During 2003, the federal funds rate fell to 1 percent and remained at 1 percent not only during the large spike in nominal growth, but also at the beginning of the sustained acceleration! Clearly, excessively low interest rates would causing a boom. The growth rates show it clearly.

However, as explained above, nominal expenditure was below trend during this entire period. If nominal expenditure begins on its targeted growth path, and if the growth rate stays constant, then nominal expenditure remains on its targeted growth path. But if the growth rate is too low or too high, then nominal expenditure will move below or above the target growth path. The only way for nominal expenditure to return to the target growth path is for it to grow more quickly or more slowly than its trend growth rate.

Nominal expenditure was above trend in the late nineties. The Fed increased the federal funds rate and the growth rate of nominal expenditure slowed. This caused nominal expenditure to return to its trend growth path. When it reached that path, nominal expenditure did not immediately return to its trend growth rate, but continued to grow slowly, less than trend, and so now nominal expenditure fell below its long term growth path.

During the period of the supposed "credit boom," nominal expenditure was growing faster than trend, but it was returning to its long run growth path (or at least approaching it.) And that was the only way it could return to that growth path.

I have been advocating that the Fed target nominal expenditure one year into the future. I favor a 3 percent growth rate, but suppose a 5.4 percent growth rate of nominal expenditure is continued. If nominal expenditure is currently on the targeted growth path, then the rule would be for nominal expenditure to grow 5.4 percent over the next year. The target for nominal expenditure one year in the future would be 5.4 percent greater than its current value.

However, if nominal expenditure is below its current targeted value, then returning to its 5.4 percent target growth path entails a more rapid growth rate for the next year. It isn't that the target of nominal expenditure is changing. The target for the level of nominal expenditure for each future quarter is determined by the rule. The growth rate, however, varies by the current value of nominal expenditure.

Using the one year rule, it is possible to construct a graph showing what the proper target for the growth rate for the next year should have been. These "targets" are not cumulative. If the policy was followed and effective, then nominal expenditure would return to its growth path and the targeted growth rate would be the trend of 5.4 percent.

Note that the only quarter when the growth rate of nominal expenditure was above the target for the year was the third quarter of 2003. That wouldn't have been a problem as long as it wasn't repeated. It was not until the first quarter 2005 that the growth rate of nominal expenditure was greater than the proper target. Further, keep in mind that nominal expenditure never reached its long term trend.

Given the norm of targeting a stable growth path for nominal expenditure, Fed policy was too "tight" during the entire period when interest rates were unusually low. If the method by which the Fed raises nominal expenditure is to lower the federal funds rate, then the federal funds rate must have been "too high."

Yet even if that is true, just because the federal fund rate must have been too high during part of that period doesn't mean that it should have been lower, or even as low as it was, during most of the period. Perhaps even lower interest rates in the middle of 2002 and then higher interest rates once nominal expenditures returned to the targeted growth path by mid 2003 would have been appropriate.

However, adjusting the federal funds rate is of doubtful utility when the goal is keeping nominal expenditure on a stable growth path. If nominal expenditure is currently on the growth path and nominal expenditure is expected to grow too rapidly, then perhaps higher short term interest rates are equilibrating. Similarly, if nominal expenditure is expected to grow more slowly, and fall below the growth path, lower short term interest rates are appropriate.

On the other hand, if nominal expenditure has already grown too slowly for a substantial period of time, perhaps even falling, and nominal expenditure is now substantially below its target growth path, (as much as 2.7 percent in 2003 or more like 15% in 2010,) then having the Fed commit to low, or falling short term interest rates is almost certainly not an appropriate approach. The depressed level of nominal expenditure reduces credit demand at any given nominal interest rate. The equilibrium level of short term interest rates can easily be quite low because of the destructive effects of the drop in nominal expenditure.

If the Fed had a commitment, not to a series of changes in interest rate, but rather to change the quantity of money however was much is needed to get nominal expenditure back to target, rising credit demand could result in increases in nominal interest rates. And so, if the only way for the Fed to increase nominal expenditure back to a target for the growth path is to lower short term interest rates or keep them low, then the low interest rates were appropriate. However, since the Fed can expand base money by purchasing a variety of financial assets, the lower interest rates are simply an artifact of the Fed's approach to policy.

Of course, certeris paribus, if the Fed purchases financial assets, this tends to raise their prices and lower their yields. But if the result is an expectation that nominal expenditure will have returned to its target growth path in the subsequent year, the direct effect of the Fed's purchases might be swamped by sales from the private sector, leading lower prices and higher yields.

For example, expectations of recovery may lead firms to issue new corporate bonds, and the increased supply of those bonds lowers their prices and raises their yields. Bond investors purchase those bonds, more willing to hold them because the firms issuing them are less likely to fail once the economy recovers. Those investors in corporate bonds sell government bonds that they were holding because of fear of default by private firms. Their sales lowers government bond prices and raises their yields, more than offsetting the direct effect of the Fed's purchases.

Now, if this effect had not occurred, then the Fed's purchases of bonds would have lowered interest rates. And this would result in lower funding costs and result in higher nominal expenditures. But, foreseeing the higher nominal expenditures that response to those higher nominal expenditures could make nominal interest rates rise.

If the Fed is committed to interest rate targeting, then it will interfere with this process. Recovery should move interest rates up, but the Fed will purchase securities in order to keep them down. Of course, as the economy begins to recover a shrinking output gap or higher inflation would cause the Fed to gradually raise its target for interest rates.

The Fed was clearly committed to making modest periodic changes in the federal funds rate. They had some general commitment to price level stability and high employment. However, price level stability meant low inflation. "Taylor rule" reasoning suggests that they were making gradual adjustments in a target for the federal funds rate based upon observations or forecasts of inflation and the output gap. Low inflation meant that the core CPI should be expected to rise 2 percent from its current level, wherever that happened to be.

In other words, the Fed was certainly not explicitly committed to a target for the growth path of nominal expenditure. If the Fed had that commitment, it is not at all clear that the extraordinarily low interest rates would have existed in 2002 through 2004. Further, if the Fed had not been wed to interest rate targeting, it is not at all obvious that an expansionary monetary policy would imply lower nominal interest rates.

In conclusion, nominal expenditure was too low during the period of the supposed credit boom. On other other hand, that does not necessarily imply that interest rates were not too low. It is certainly possible that excessively low short term interest rates were one of the many factors resulting in excessive increases in home prices. So the Fed's approach to monetary policy could be a contributing cause of the speculative bubble in home prices. And that speculative bubble certainly resulted in a misallocation of resources that can only now be gradually corrected by shifting labor to more productive avenues and producing new capital goods.

Worse, the end of the speculative bubble, and the losses of the financial firms that had lent into that bubble, were the key trigger for the disastrous drop in nominal expenditure in late 2008. And now, the absence of a clear commitment to returning nominal expenditure to its previous growth path is resulting in even more severe difficulties with production and employment. A policy approach of gradual decreases in short term interest rates, and further, dealing with the zero bound by promising to keep short term interest rates low for an extended period of time, not only is again not getting nominal expenditure back to its trend growth path, it might also be responsible for a future speculative bubble.

Saturday, March 20, 2010

Banks generally create liquidity. They borrow short and lend long. Banks also create money. The greater part of the quantity of money is made up of bank liabilities with very short terms to maturity, payable on demand or overnight. The banks use these liabilities to fund assets with various terms to maturity, but generally, very little of it is so short. (With reserve balances at the Fed being so large, the last two years are an exception.)

Money is "perfectly" liquid, more or less by definition. And so, by creating money, banks are creating "liquidity." Perhaps it is natural to confound the creation of liquidity with the creation of money. However, this is a mistake.

Suppose a bank funds 30 year home mortgages with 5 year nonnegotiable certificates of deposits. The bank has created liquidity, but 5 year nonnegotiable certificates of deposits aren't very liquid and are certainly not part of the money supply. The bank has created liquidity because they are more liquid than the 30 year home mortgages.

Generally, the creation of monetary liabilities by banks involves the creation of liquidity. However, not all creation of liquidity is closely associated with the creation of money.

Some adherents of the "Austrian" school of economics, particularly Rothbardians who insist that fractional reserve banking is fraud, have expanded their critique of banks that borrow using monetary liabilities. (I had in mind, Walter Block, and here is a link to a paper with William Barnett. A commentor helpfully provided a link to Bagus.) While claiming that any creation of liquidity must be fraud strains credibility, some have argued that, any creation of liquidity leads to malinvestment. In other words, if banks borrow shorter than they lend, the result is malinvestment.

The idea seems simple. Those borrowing from banks fund investment projects that take a long time to mature and generate consumer goods. Those lending to banks at shorter terms to maturity are only committing to save, that is, refrain from present consumption, for a shorter period of time. When those saving demand repayment and use the proceeds to purchase consumer goods, then there will not be enough consumer goods because the projects that were being funded have yet to mature. The projects that the banks were funding will be abandoned and left incomplete. The partially finished projects represent malinvestment. The losses are caused by the banks' failed effort to create liquidity.

There is certainly an element of truth in this story. If all investment projects were funded by savers who were committed to seeing them through to completion, then the problem described above could not develop. However, having financial intermediaries that borrow short and lend long is not necessary for the problem to occur, so that requiring financial intermediaries to match maturities, fund loans with deposits of an equal term to maturity, is not adequate to avoid the problem.

Further, if draconian government intervention did prevent the problem from developing, for example, implementing Keynes' notion that savers should be married to investment projects (Catholic-style, with no chance of divorce,) then few long term investment projects could be funded.

Suppose the investment project is planting a pine forest for the production of paper. The trees mature after 20 years and will be harvested. It would be possible for the forester to fund the project with his own funds and then plan to wait 20 years, sell the trees, and make a profit. Such a plan marries saving with investment.

However, the notion that this project requires that there be some single individual willing to wait 20 years is an error. The project could be funded by 20 people each waiting one year in sequence. The first person refrains from consumption the first year and that frees up resources to plant the forest. The next person refrains from consumption in the second year. The consumer goods he gives up go to compensate the person who waited the first year. That person can consume the goods the second person didn't. And then, for the third year, a third person refrains from consumption, and the goods go to the person who waited the second year. And so on, until in the final year, when the project matures. The twentieth person gets the product of the investment project compensating for consumer goods that were given to the person who waited for the 19th year.

If this method of providing resources for long term projects is somehow prohibited, and projects are only are permitted if some individual is willing to wait 20 years to get the benefits, then few such projects will be permitted. Forests, homes, durable machinery, and the like, will generate very high returns, but total output will be lower and people poorer. In fact, if it were not for capital markets, then there would be a very strong argument for socialization of investment. How else could society obtain the benefits of long term projects?

So how can the forester avoid waiting 20 years? How can the required saving be passed on to twenty people (or however many necessary?) The forester can sell the forest after the first year. And then the next forester sells it after another year, and so on. Of course, some foresters might hold it longer, and others less. But the notion that someone must commit to holding it 20 years for the project to be profitable is so wrong as to be absurd.

Suppose, the forester specifically plans on selling the forest after only 10 years. Perhaps he is old and will want to retire. Perhaps he has no heirs who want to be foresters. However, this plan entails liquidity risk. It depends on finding a buyer in 10 years for the forest. If there is no one willing to pay anything, then the partially grown forest will be worthless, and the forester will have lost everything. Fortunately, that is unlikely, but what kind of return the forester is going to get for his investment will depend on market conditions at the time he intends to sell. The forester is bearing liquidity risk.

The forester bears many risks. There are risks associated with production. Perhaps there will be a forest fire or an outbreak of disease. There is also the risk that the demand for pulp wood will be lower or even nonexistent at harvest time. And if the forester plans to sell the forest before harvest, then he also bears liquidity risk.

Could government interventions be introduced that would prevent the forester from taking this risk? The answer is yes. Simply prohibit sales of capital goods. Then the forester could not plan to use this approach to shift the need to wait to some other investor. Of course, forests will only be planted by individuals willing to wait 20 years for the output. Presumably, the returns will be higher and paper more expensive.

Rather than operating as a sole proprietorship, suppose the forester incorporates, and sells out. Assuming he profits, then the forester-promoter can take all of his funds from the forest project, buy a 10 year bond (or whatever) and bear no further risk. While the stock investors could each plan to wait 20 years for the harvest, each can instead plan to sell their stock to someone else at any time. The firm has no leverage and the stockholders bear all the risk. This includes risk for failed production and reduced demand for pulpwood. For each of them, any desire to sell to someone else before the forest matures and is harvested involves liquidity risk. Will there be someone else willing to take their place in funding the project? And on what terms?

Could government intervention be introduced to avoid the liquidity risk? Again, by prohibiting a secondary market for stock--a stock market, this particular means of generating liquidity could be prohibited. Of course, if the corporation sold the forest and paid out the proceeds as a dividend, liquidity still could be provided. So, outlawing the sale of capital goods by corporations, as well as prohibiting a secondary market in equity would be necessary.

Suppose that instead of funding the project entirely with equity, the project is funded partially with debt. The firm funding the forest buys out the initial forester by selling stock and 20 year negotiable bonds. So, just like the stock investors, those funding the project bear liquidity risk to the degree they intend to sell the bonds before maturity to someone else who will take over funding the project.

In some sense, those holding the equity continue to bear all of the other risks--fire, disease, and less demand for pulpwood. They also bear some residual liquidity risk. The stock investors may want to sell out and obtain their funds before the project matures in 20 years. However, the reality is that the equity investors' risk is limited by owners' equity. If the losses are too severe, then the firm will become bankrupt, and the bond holders will receive only partial payment.

Could the government prevent the bond investors from bearing this liquidity risk? Yes, by outlawing negotiable bonds. Then only those willing to wait the full twenty years would be willing to buy the bonds.

Now, suppose that rather than fund the project by issuing stock and 20 year bonds, the project is funded by stock and 1 year bonds. When the bonds come due, the corporation must sell new bonds to pay off the old bonds. Of course, it might sell the forest or new shares of stock. But it must somehow come up with the needed funding. Those providing funding for the project by purchasing the 1 year bonds appear to bear insignificant liquidity risk. The stockholders still bear all of the risk for fire, disease, and a loss of demand for pulpwood, and they bear all the liquidity risk.

Of course, like all the risks of the project, the stockholders bear the risk up to the limit of their investment. If the losses are too great, then the firm will fail and become bankrupt. The one year bond holders will receive only partial repayment and take a loss.

Could government intervention prevent a firm from creating liquidity by funding a long term project with short term bonds? While it would require substantial regulation, something like the SEC could protect stockholders and bondholders from this sort of risk by requiring that projects be funded with bonds of at least equal maturity. Of course, this just means that these projects are funded by long term bonds, and those bond holders will bear more liquidity risk. Avoiding all liquidity risk would require that the long term bonds be nonnegotiable, that there be no secondary market for stock, and finally, that capital goods not be alienable.

And now, for banks. It would be possible for a bank, as financial intermediary, to fund the project by purchasing 20 year bonds. If the bank obtained to funds by selling 20 year CDs, it would be matching maturities and creating no liquidity. If the 20 year CDs were not negotiable, then the depositors would bear no liquidity risk, but would need to wait until the project matures. There would remain the risk of fire, disease, or reduced demand for pulpwood. The stockholders of the forestry corporation would bear any such losses to the extent of their investment. If losses were so great as to wipe out the firm's equity, then it would become bankrupt and fail. If it fails, then the bank would take a loss. If the losses are so great to wipe out the capital, or owners' equity of the bank, then it too will fail and be unable to pay off its depositors. And then, the depositors would take a loss.

If the CDs are negotiable, then the depositors bear the liquidity risk to the degree they plan to sell the CDs before maturity. Both the stockholders of the bank and the forestry corporation bear some residual liquidity risk. But to the degree the project is funded by negotiable long term CDs, and the holders of the CDs intend to sell the bonds before they mature, then they they bear a substantial portion of the liquidity risk.

Could the government protect the CD holders from bearing this liquidity risk? It simply could ban negotiable CDs. If banks were required to match maturities, then only those depositors willing to wait 20 years for the proceeds of the project would buy the CDs. Liquidity risk would not be a problem.

Finally, the forestry corporation might sell 20 year bonds to the bank. And the bank might purchase them, but this time the bank could obtain funding by selling one year CDs. Finally, the bank is creating liquidity. The stockholders of the forestry company bear the risk of loss due to production failures or a decrease in product demand. They have a residual liquidity risk to the degree they want to sell out before the project matures. The bank bears liquidity risk to the degree the project is funded with the 20 year bonds. It bears some risk that the project will fail, and the losses will be greater than the forestry company's capital. This is called credit risk.

By creating liquidity and funding the 20 year bonds with one year CDs, the bank has shifted liquidity risk away from the depositors. It has also shifted credit risk as well. However, there remains residual credit and liquidity risk for the depositors. If the bank suffers losses, perhaps because of credit risk, but also due to liquidity risk, and those losses are greater than the bank's capital, then it will fail, and the depositors will take a loss too.

How does liquidity risk appear for the bank? As the short term CDs come due, the bank must find funds to pay them off. It must sell new CDs, or else sell the bonds it is holding, or perhaps sell new stock.

A banks is solvent but illiquid if it would be able to pay off CDs as they come due if only it can borrow funds at reasonable interest rates or else sell off some or all of the bond portfolio at reasonable prices. It is the absence of such "reasonable" interest rates or prices, perhaps what is better described as changes in what interest rates are reasonable, that results in the losses relevant to liquidity risk.

Could the depositors be protected from this residual liquidity risk by government intervention? Yes, banks could be required to match maturities and not create liquidity. Of course, that means that the bank would be funding the long term project with long term CDs. Assuming those are negotiable, the depositors are being protected from residual liquidity risk by requiring them to bear all of the liquidity risk. As explained above, by making the CDs nonnegotiable, they could be protected from that liquidity risk too.

The point of these examples is to show that the creation of liquidity by banks is just one way of sharing the risks that are inherent from having savers share the funding of long term projects. As always, the savers retain some residual risk. Those who are bearing risk for them might become bankrupt, and provide only partial repayment.

So where does that leave concerns about malinvestment? If draconian interventions are implemented, of which requiring banks to match maturities on deposits and loans would be just the start, then every project will have savers who wait until it matures. But if savers are allowed to share the funding responsibilities, then it is possible that there will be a demand for consumer goods before the project matures.

If the forester cannot find someone to buy the forest after 10 years, then he will not be demanding any consumer goods. More realistically, the amount of consumer goods he can obtain after 10 years depends on what someone else is willing to pay for a forest that will be mature in 10 more years. On the other hand, if these losses are shifted to stockholders, long term bond holders, or even a residual risk to short term depositors, the effect is the same. If the corporation is funded with short term bonds, then it may be bankrupt, but the forest that will mature in 10 years is still there for a reorganized firm. Similarly, if a bank fails, the bonds with 10 more years to maturity and the forest that will be harvested in 10 years remain. Just because there is a bankruptcy, there is no need to abandon the valuable forest.

It is, however, possible that an increase in the demand for consumer goods in 10 years would result in the abandonment of the forest project. Suppose that each year, forest management requires additional resources. Forest fighting, cutting away diseased trees, clearing brush--any number of things are possible. If the demand for consumption in 10 years is so great that those resources are more profitably used to produce current consumer goods, then they will be stripped away from the forest, and it will sit abandoned. If the unmanaged forest is worthless, at harvest time, then it will be a total loss. And if that is that is the better allocation of resources, then the forest should be abandoned.

Avoiding such losses would be the benefit of draconian regulation to require that savers be married to investment projects. And the added productivity of all of those long term projects that could not be undertaken because they lack a spouse, would be the cost.

Friday, March 19, 2010

The concept of "Fractional Reserve Banking" is tied to an unrealistic narrative regarding the nature of banking. While the traditional account of fractional reserve banking includes many truths, it is embedded in a framework that focuses on banks as storehouses of money rather than as financial intermediaries. In Fractional Reserve Banking 1, I gave such an account.

As financial intermediaries, banks borrow funds by issuing a variety of financial instruments. These bank liabilities serve as assets to households and other firms. All of these bank issued financial instrument can substitute for one of the functions of money--the less central store-of-wealth function. And, of course, some bank liabilities can substitute for the core function of money, as media of exchange. Under modern conditions, transactions accounts at banks are money, and make up the most important part of the total quantity of money.

Those bank liabilities that serve of as medium of exchange create special problems because of some of the essential qualities of the medium of exchange. People accept money in payment even if they don't intend to hold it. People can and do realize an increase in the demand for money by reducing habitual expenditures on other goods and services.

However, the fundamental nature of bank borrowing--even using monetary instruments--is based upon the demand by firms and households to hold those liabilities. Banks, as financial intermediaries, must find willing lenders. The "problems" that are seen by critics of fractional reserve banking are not problems with the banks, but are rather problems with the hand-to-hand currency. The banks adjust the amount of money they issue to reflect the "market share" of banks in the total demand for money. If the issue of hand-to-hand currency similarly adjusted in that fashion, the "problems" of fractional reserve banking would not develop.

The inflationary or deflationary impacts of fractional reserve banking are nothing more or less than showing how the market adjusts to a change in the demand for hand-to-hand currency, when the quantity is assumed to be fixed. It is little different from the fundamental proposition of monetary theory, explaining how the market adjusts the demand to hold money to a given quantity of money, or alternatively, how the real quantity of money adjusts to the real demand for money by changes in its purchasing power.

To explore these questions, consider an alternative conjectural history of banking. Again, money is initially made up of tangible, hand-to-hand currency. It could be gold coin, but paper fiat currency is more familiar.

Banks, however, develop as financial intermediaries. Money lenders, who are lending their own capital, begin to "leverage" by borrowing additional funds to lend as well. Suppose the banks make 90 day commercial loans to businesses. Aside from the capital invested by the owner, the loans are funded with 90 day certificates of deposit.

The banks are borrowing money from depositors--firms and households--with money to lend. And then the banks take those funds and lend them to firms that need to finance their operations. The banks charge more for these commercial loans than they pay on the deposits, which generates their revenue. After subtracting operating costs, the result is the banks' profit.

What benefit do depositors receive from lending to banks instead of directly to the firms? There may be some benefit in that the banks can issue CDs in various small or large denominations convenient to depositors while making loans in the amounts convenient to the firms needing to borrow money.

However, the key benefit is that depositors receive the benefits of diversification. If a small lender made a loan to a single business and that business failed, the borrower could take a substantial loss.

That the banks make loans to a variety of firms allows them to earn a given return with less risk of loss. While some of the businesses may fail and not fully pay, each bank is compensated by interest earned from all of the loans that are repaid.

From the depositors' point of view, this risk is buffered by the bank's own capital, or net worth. The bank must suffer sufficient losses, from bad loans or any other source, to run through all of the funds contributed by the owners, before the bank fails, and the depositors take a loss. However, because the banks can diversify and make loans to a variety of businesses, the chance that the losses will be so great as to cause a bank to fail is diminished.

So far, the banks have no part in the payments system. Depositors bring in currency to deposit. The banks lend businesses currency. Presumably, the businesses borrow currency to make payments with it.

As the bank undertakes its business through time, receiving deposits, making loans, receiving loan repayments, paying off deposits, it will need to maintain currency balances, much like any other business. Like any other business' money holdings, it will change based upon money received and paid. If new deposits plus loan repayments are greater than the redemption of deposits and new loans, a bank's currency holdings will rise. If new deposits and loan repayments are less than redeemed deposits and new loans, then a bank's currency holdings will fall.

Bank depositors often rollover their funds. When a CD matures, the depositor receives a new CD from the bank instead of currency. This reduces the banks currency needs. Similarly, a bank can rollover loans. If a business borrower is financing inventory with commercial loans, a bank can renew the loans without insisting that its customer show up at the bank and pay currency. The business can use the currency it receives from selling its products to purchase additional inventory.

A bank, as financial intermediary, needs to keep deposits and loans in balance. The interest rates paid on deposits and the interest rates charged on loans should be set to maintain the balance. If interest rates on deposits and loans are too low, new loans will be greater than new deposits. Loan repayments and deposits will generate too little currency to cover new loans and the repayment of deposits.

On the other hand, if interest rates on loans and deposits are too high, then new deposits will accumulate more quickly than new loans. A bank's currency holdings will build as loan repayments and new deposits outstrip new loans and the repayment of deposits.

However, even if the interest rates a bank pays and charges keeps deposits and loans balanced over time, its cash holdings will vary with daily variation in deposits, withdrawals, loan repayments and new loans.

The average amount of currency the bank holds could be expressed as a fraction of total assets or of deposits. But it unclear why such ratio would be especially significant.

Because the bank is assumed to borrow by issuing 90 day CDs and then make 90 day loans, it doesn't create liquidity. Suppose that one of the bank's customers asks for a six month loan, rather than the traditional 90 day loan. Suppose the bank agrees, but rather than finding a depositor who wants to purchase a 6 month CD, it funds the loan with a 90 day CD. When that CD comes due in 90 days, it must simply issue a new CD to pay off the existing CD.

This transaction creates liquidity. The six month loan is transformed into two sequential 90 day CDs. The depositors that are ultimately funding the six month loan only tie up their money for half of that time.

The bank, however, is taking liquidity risk. When the first CD comes due, the bank must somehow obtain the funds to pay it off. Perhaps a higher interest rate must be paid. Or, maybe the 6 months loan must be sold to a third party at a loss. But, of course, it is possible that the bank will have no trouble issuing a new C.D. to pay off the old one. Perhaps even the initial lender will roll-over his funds and purchase an additional C.D.

If the liquidity risk does result in some loss, then it comes out of the bank's capital. If losses from liquidity risk are severe enough, then the bank might run through all of its capital. It will be bankrupt. It will be unable to fully pay off all depositors.

All bank risks, including both credit and liquidity risk, have an impact on depositors. The bank's capital provides a partial shield or buffer. Bank capital increases the size of the losses a bank can suffer, that the owners of the bank can suffer, before the depositors must also take a loss.

It is this scenario where a bank can be said to be illiquid but not insolvent. If someone were willing to lend to the bank at a "reasonable" interest rate, then the bank can pay off maturing deposits, and eventually, its loans will mature and it will be able to repay the deposits. Or, if someone is willing to pay a "reasonable" price for the bank's loan, then the bank will be sell the loan and pay off the deposit. The inability of the bank to borrow at all, or sell its loans at all, or to borrow at only excessive interest or receive only prohibitively low prices for loans, is what results in the bank's default and failure. While the bank may fail, the losses to the depositors could be minimal.

Suppose that one of a bank's depositors rolls over less funds than usual. When asked what happened, the depositor explains that something might come up about two months from now, so that he cannot tie up as much money as usual in the 90 day CDs. The bank could offer to issue a 30 day CD. If the bank doesn't find someone interested in borrowing for 30 days, and instead funds a 90 day loan, the bank has created liquidity. After 30 days, the bank must either sell the loan to obtain the funds to repay the deposit, or borrow new funds. It could issue a standard 90 day CD or else another 30 day CD.

The result is no different from funding a 6 month loan with a 90 day CD. The bank has created liquidity and bears liquidity risk. Of course, the 30 day CD has a shorter term to maturity.

Generally, liquidity-creating banks can fund their operations with deposits of a variety of maturities and make loans of a variety of maturities. A bank's loans and other assets create credit risks. The mismatch between the maturities between a bank's loans and deposits creates liquidity risk. These risks can be source of bank losses. A bank's capital creates a buffer for taking losses before the bank fails and depositors take losses.

The banks' currency holdings (or reserves) is related to liquidity risk. If a bank needs funds to make a new loan or pay off deposits, and the amount of loans being repaid or else new deposits generate insufficient currency, then, at the very least, the bank must turn down loan business, or worse, will be unable to meet redemption demands. A bank's currency holdings provides a buffer against those adverse consequences--particularly the chance of default.

Fortunately, banks can make "loans" by holding marketable securities that can be sold to obtain funds. Also, banks can borrow short term, perhaps from other banks. From the point of view of the individual bank, the management of its currency holdings is largely a matter of trading off the transactions costs of selling securities or borrowing short term against the opportunity cost of holding zero-interest currency.

It would be possible to calculate the ratio of currency (reserves) to total assets, some subset of assets, total deposits, or some subset of deposits. It unclear why any of those ratios are of significance. What is important is the variance of the bank's currency balance, the interest rate that can be earned on liquid assets, and the transactions costs of trading securities or obtaining short term loans.

A 30 day CD has a very short term to maturity, however, that is hardly the limit. Banks could borrow for even shorter terms to maturity. They could borrow by issuing 14 day CDs. If the bank pledges some kind of securities as collateral, then these would be "repurchase agreements," and 14 days is a common maturity in that market. However, any term to maturity is possible.

Overnight is especially important because modern experience has shown that a payments system can be developed using overnight deposits. But 5 hour, one hour, 10 minute, 30 second, or even one nanosecond are possible--the term to maturity can approach zero. At some point, there could be no other reason than regulatory evasion to avoid describing the transaction as a traditional "demand deposit." That is, the bank borrows funds from depositors, promising to repay the funds at the request of the depositor.

Some critics of banking have insisted that if a bank promises to repay funds on demand, then that bank is obligated to store the money and keep 100 percent reserves. If such a rule is implemented, then banks must simply promise to repay money one nanosecond in the future, with automatic rollovers until notification. After the initial deposit, at any point in time, the funds are maturing, and the depositor can state that the rollover agreement ends now, pay up.

From the bank's point of view, its situation isn't much different. The problem isn't how many depositors could demand currency at any point in time, it is rather how many actually will demand payment in currency. And that calculation simultaneously includes estimates of how many loans will be repaid in cash at that point in time, how many new cash deposits will occur, and, while not relevant for the possibility of default, how many borrowers will request new loans.

Do these banks have any macroeconomic significance? Yes, it is almost certain that financial intermediaries would cause inflation. Return to the simplest scenario where the banks fund 90 day commercial loans with 90 day CDs. The banks create no liquidity. The CDs are not used as the medium of exchange. All payments are made with currency. Like any other businesses, banks hold currency for making payments.

If the financial system is very primitive, so that many households and firms are saving by accumulating money balances, then the development of these banks allows them an alternative method of saving. Rather than putting currency in the cookie jar, or burying it in the backyard, to save up to buy a car, buy a house, pay for college, for retirement, replace income that might be lost due to an extended illness, or start a business, households and firms that were accumulating money balances can lend the funds to banks.

This results in a decrease in the demand for money--for the gold coins or paper currency that serves as the medium of exchange. If the quantity of money, of hand-to-hand currency, does not change, then the market process that adjusts the real quantity of money to the real demand for money is for its purchasing power to fall. The money prices of all goods and services must rise.

For example, if the development of banking results in people shifting 50 percent of their money holdings to banks, having hoarded all of that currency for purposes of saving, then other things being equal, the price level would need to double. Each dollar would purchase approximately half as much. And the total value of all the currency would just match the amount households and firms want to hold to make transactions.

Of course, the banks do need to hold some currency, as explained above. If that is treated as a separate demand, then the increase in the price level would be less than in proportion to the decrease in the demand for currency by household and other businesses. What is interesting, of course, is that if the banks were not financial intermediaries, holding modest amounts of currency, but were "money warehouses," then moving "savings" from the cookie jar or backyard to the banks would leave the demand for currency unchanged, and there would be no inflationary impact.

So, banks, even creating no liquidity, and operating as financial intermediaries, could create inflation by reducing the demand for currency. Currency serves as a store of wealth as well as a medium of exchange. Bank CDs are an asset that savers can hold. This new financial instrument that competes for household savings results in a loss in "market share" for currency, a decrease in the demand for currency, and so, given the quantity of currency, a lower purchasing power of currency, and a higher price level.

Considering this scenario, it is clear that the problem isn't that banks have introduced a superior outlet for saving, but rather the problem is that the quantity of currency fails to adjust when the demand to hold it falls.

Suppose the quantity of currency was managed by a monetary authority whose mandate was to maintain the purchasing power of money. If the demand to hold currency as a store of wealth were to fall, because household and firms begin to hold 90 day CDs at banks, then the monetary authority would need to reduce the quantity of currency to reflect that lower demand. If the demand to hold money fell in half, then the monetary authority would need to drop the quantity of money by 50 percent. The nominal quantity of money would match the amount households and firms still want to hold for transactions. There would be no decrease in the purchasing power of money or increase in the price level.

If the quantity of currency is fixed, then it is possible for there to be a financial crisis centered on the banks, even if they create no liquidity, much less are involved in the payments system. Banks can, of course, make bad loans. If there are enough bad loans, the banks can suffer losses. If these losses are large enough, the banks may run through all of their capital, become insolvent and bankrupt. The depositors can take a loss. Fear of that prospect could lead depositors to stop rolling over their CDs and as they mature, return to storing currency in cookie jars or burying it in the back yard.

Suppose worries about the banks failing lead to an 20 percent increase in the demand to hold currency. If the quantity of currency is unchanged, the purchasing power of money must rise and the price level fall by 20 percent. This will cause the real quantity of currency adjust to the now higher demand. The banks should be hedged against this risk. While the real value of their liabilities, the CDs, increase 20 percent, the real value of their assets, the loans they have outstanding, also increase the same 20 percent.

But those borrowing from the banks are almost certainly not hedged against this decease in the price level. The cash flow that they would used to pay the loans is reduced. So, the first "cushion" is the capital, or net worth, of the borrowers. If it is too little, then they will be bankrupt and unable to pay their bank loans. Then, the banks receive only partial payment of the loans. This reduces profit and if large enough results in loss. If the losses are greater than the banks' capital, then banks fail. Depositors take a loss.

Of course, the real value of the partial funds the depositors receive from the bank is larger. Perhaps there is no real loss to the depositors. However, if there is any nominal loss, then holding currency would provide a larger real gain than bank deposits. And so, expectations of this scenario provide a rational motivation for depositors to collect on CDs as they come due and hoard currency.

Further, this same logic applies to the banks. If the banks expect that an increase in the demand for currency will develop, and the result will be nominal losses on loans, they can reduce their losses by accumulating currency. As old loans are repaid, they can accumulate currency rather than make new loans.

If the increase in the demand for currency was due to a correct anticipation of bad loans--credit risk-- then these losses due to an increase in the demand for currency and a decease in the price level compound the losses. The problem isn't that the banks are creating money. It isn't that they are creating liquidity. The problem is that the demand for currency increased, the quantity of currency remain unchanged, and the banks lent money to people who suffer losses due to the decrease in the price level.

With more sophisticated financial markets, it is possible that banks as financial intermediaries would have little impact on the demand for currency. For example, suppose households and firms wanting to save are purchasing 90 day Treasury Bills. Banks develop, as financial intermediaries, competing with the government by issuing 90 day CDs. Rather than imagining that nearly all the funds deposited into banks comes from currency hoards, in such a scenario, the more plausible, and more limited, source of funds would be those that would have been lent to the government. And while higher yields on these financial instruments might encourage those holding currency to manage their balances more closely and put more in a bank, this effect could be on the same order of magnitude as attracting new saving. That is, households might reduce consumption expenditures out of current income and deposit funds into CDs at banks.

By creating liquidity, financial intermediaries can have a much more significant macroeconomic impact. While creating liquidity is risky because of a mismatch between the maturity of assets and liabilities (loans and deposits,) the key macroeconomic impact is that banks creating liquidity can reduce the term to maturity on their borrowing. This makes bank liabilities into closer substitutes for currency. If banks fund their operations with deposits that can be used to make payments, a very large substitution away from currency is possible because banks are competing with the core role of currency as medium of exchange.

Consider a bank that funded a portfolio of 30 year treasury bonds with 10 year CDs. While such a bank would be creating liquidity, it is unlikely that 10 year CDs would provide a good substitute for currency and so would have much impact on the demand for currency. No, it is the very short terms to maturity, in particular, overnight borrowing, that have been shown to provide a near perfect substitute for money. Money deposited in such an account, with automatic rollovers, allows depositors to claim their funds whenever needed by providing notification that some or all of the funds should not be rolled over again.

While in the U.S., transactions accounts are not "overnight," but rather payable on demand, a payments system could be constructed using overnight accounts. When checks or electronic payments generate claims against such an account, the bank would be obligated to cease rolling over the amount of funds needed to cover the claim.

If financial intermediaries are able to develop a payments system, then a very significant decrease in the demand for currency is possible. If the MZM to currency ratio is taken as typical, then perhaps the demand for currency could be reduced by 90 percent. If the quantity of currency is fixed, then a 90% decrease in the demand to hold currency would require a roughly ten fold decrease in the purchasing power of currency. The price level would need to rise by a factor of 10.

The process by which this would occur is very similar to the traditional "money multiplier" story. Banks begin to offer financial instruments that provide a good substitute for currency. The demand for currency falls, as the demand for these bank-issued instruments rises. The banks meet this demand by issuing the instruments. The banks receive currency in exchange for those deposits, and then lend the money out, by making commercial loans or perhaps by purchasing liquid securities. If the banks are directly involved in the payments system, they can simply create deposits for borrowers, and as the borrowers spend the money and the checks clear, reserve balances (perhaps currency or balances at the clearinghouse) are shifted to the banks of those selling to the borrowers. And now those banks have excess currency (or clearing balances) and expand lending.

This process, however, is just an example of the fundamental proposition of monetary theory. Currency serves as the medium of exchange. People (including banks) accept it in payment without intending to hold it, and if they are holding more than they want, they spend it. The banks accept money in payment for deposits, and they spend it by purchasing securities or making loans. Monetary equilibrium returns when the real value of money (currency in this case) decreases to match the real demand.

Certainly, if banks begin to issue very liquid, short term deposits, and go so far as to develop a payments system, their demand for currency would rise. Retailers regularly make currency deposits at banks and withdraw currency from banks to make change. However, this demand should not be strictly proportional to the quantity of total deposits, or any class of deposits. There are just additional flows of currency to and from banks, and this additional variance in the level of currency holding, along with the interest rates on various short term assets and the transactions costs of those assets determine the optimal level of currency.

If banks organize a clearinghouse and deposit currency at the clearinghouse, then the banks' clearing balances creates a substantial demand for currency. However, the banks could easily avoid the opportunity cost of settling with currency by having the clearinghouse operate as a money market mutual fund.

If a banking system, based upon financial intermediation, gradually develops more liquid deposits and goes so far as to develop a payments system, the result could easily be a substantial reduction in the demand for currency. As this lower demand to hold currency develops, and the price level rises, then all the nominal values in the economy, including the dollar value of deposits, loans, and all the currency payments rise as well. And so the nominal demand for currency holdings by banks rise in proportion as well.

Suppose the quantity of currency were not fixed, but rather a monetary authority manages its quantity to offset any changes in the demand to hold it so that its purchasing power remains stable. As financial intermediaries develop shorter term, more liquid, deposits, or even a payments system, so that the demand for currency falls, then the monetary authority would be obligated to reduce the quantity of currency. The purchasing power of currency would be unchanged.

If money is defined as the medium of exchange, and bank deposits are used to make payments, then banks are creating money to match the demand for households and firms to hold (and perhaps use for payments) this new class of financial instruments. The banks certainly require currency for their operations, and the monetary authority's responsibility is to keep the quantity of the currency issued equal to the total demand to hold it, both by banks and households and other firms.

Considering this scenario, in what sense are the banks creating money equal to a multiple of reserves? Certainly, it is possible, even likely, that the monetary instruments bank create will be a multiple of the amount of reserves, currency holdings or clearing balances, that the banks hold.

But why is that ratio significant? Fundamentally, the banks supply monetary liabilities as demanded. They, like everyone else, demand some currency. They, like everyone else, with an excess supply (or demand) for money adjust spending. If the quantity of currency is taken as fixed, then equilibrium requires changes in the price level so that the real quantity of currency adjusts to the real demand by households, banks, and other firms. But if the monetary authority adjusts the nominal quantity of currency so that it remains equal to the total demand to hold currency by households, firms, and banks, then the total quantity of deposits issued by the banking system would not be inflationary. The quantity of deposits issued by the banks would be limited by the demand by households and firms to hold them.

An individual bank in a banking system must fund its assets. Any banks issuing deposits that are used as money can write a checks to purchase a securities or provide deposit accounts to borrowers. But the check used to purchase the security or the checks written by the borrowers end up deposited at other banks, generating adverse clearings. A bank must either sell some other asset or else find someone willing to lend it money, generally, someone willing to hold its deposits.

But all that process really does is limit each bank's supply of monetary liabilities to a market share that depends on depositor preferences. With a clearinghouse, any bank that issues too many deposits relative to customer preferences is going to see depositors shift funds to other banks and have adverse net clearings. And any bank that fails to create enough deposits to match the market shares reflecting depositor preferences will receive additional deposits.

Of course banks can impact depositor preferences. Even if they are tied together by a clearinghouse and accept each others checks (or electronic payments) for deposit at par, each bank can adjust the interest rate it pays to depositors to impact its market share.

What is important, however, is that the clearing process doesn't control the total quantity of deposits. As the logic of the "money multiplier" suggests, an individual bank that creates a deposit and creates a loan can expect to suffer adverse net clearings as the borrower spends the funds and they are deposited in other banks. However, the other banks receive those funds in deposit, and so the total quantity of deposits in the system adjust to the amount of loans. The banks receiving the new deposits have favorable clearing balances. Perhaps they could lend those funds to the bank that made the loan. And then, total loans and total deposits have increased.

However, just as each bank is limited to issuing monetary liabilities in proportion to market shares depending on the preferences of depositors, the total issue of all the banks is limited by the preferences of those holding money by the market share of deposits relative to currency. If all the banks issue monetary deposits beyond the level consistent with the share of total money holdings households and firms prefer to hold in the form of deposits, then banks will be required to obtain currency in order to pay off depositors.

And the opposite is true as well. If banks want to operate a payments system that includes fiat paper currency, they need to accept it for deposit. If banks issue too few deposits, then they will see increases in currency deposits. New deposits are created.

Just as an individual bank can impact its market share of monetary liabilities by changing the interest rate it pays on deposits, the interest rates that each bank sets impacts the market share of deposits in total money holdings. If banks pay higher interest rates on deposits, then one effect should be a larger demand for deposits relative to currency. And banks will expand the deposits they create to match the demand. And the opposite is true as well. Just as each bank can reduce its individual market share by lowering the interest rates it pays on monetary deposits, the banking system does the same relative to the market share of deposits in the total quantity of money.

Certainly, banks as financial intermediaries are imperfect, and are subject to failure due to credit risk--making bad loans. Further, if they create liquidity, they face an additional source of risk, that could also lead to failure. Since banks have very little opportunity to make overnight (or less) loans, if banks are creating monetary liabilities, they will face liquidity risk.

And while banks funding their operations partly with monetary liabilities can lend money into existence, they remain limited individually to their market share of the total amount of deposits by the preferences of depositors. Further, they remain limited collectively by the total market share of deposits relative currency as determined by the preferences of those holding money.

The "problem" of banks with "fractional reserves" creating a multiple expansion of the quantity of money with inflationary consequences is really a problem of the quantity of currency failing to decrease when the demand to hold currency falls. The banks adjust the quantity of deposits they create according to the preferences of those using money. If the quantity of currency is assumed to be fixed, then it is failing to adjust to reflect its market share as determined by those holding money. But if there is a monetary authority manipulating the quantity of currency, "the problem" is that the monetary authority is not adjusting the amount it issues to reflect the preferences of those holding money.

In conclusion, the money multiplier process that describes a banking system receiving deposits of currency, and then having that currency lent, and then deposited and the lent again, is really a story about how the quantity of currency has failed to decrease in response a decrease in demand because banks are providing a product that the households and firms using money find superior. Further, in the reverse situation, the economic difficulties that develop when depositors abandon banks and instead choose to hold currency occur because the issuer of currency is failing to increase the quantity of currency to meet the added demand.

It only by starting with the assumption that the quantity of currency fixed and unresponsive to changes in the demand to hold it, and that the sort of "banking" system that has no impact on the demand for currency, 100 percent reserves, is the base line, does the conventional analysis of fractional reserve banking become sensible. If instead, the baseline is banks as financial intermediaries, providing through liquidity or a payments system, financial instruments that are competitive with currency, then the ratio of currency or other reserves to some class or other of deposits fades to insignificance. The problem, instead, is the failure of the quantity of currency to adjust to changes in the demand to hold it. With a monetary authority manipulating the quantity of currency, the problem is with the monetary authority.

Thursday, March 11, 2010

The Cobden Center is a think tank devoted to social progress through honest money, free trade, and peace. Unfortunately, one of the writers associated with the Cobden Center, Tony Baxendale, considers ordinary banking to be dishonest. See this article here.

The term "Fractional Reserve Banking" is misleading. Bank reserves are made up of vault cash and balances held in deposit accounts at the central bank. "Fractional Reserve Banking" means that these reserves are a fraction of something. What exactly? And why is that a relevant criterion?

To explore this issue, I am going to describe two very different conjectural histories of banking. Both begin without banks, and with all money being tangible, hand-to-hand currency. It could be gold coins, but I will stick with the more familiar government fiat currency.

The first history has banking develop out of money warehouses. To avoid theft, people pay to have money stored. The second history instead has banking develop out of financial intermediation. Banks borrow money and then lend it out.

Again, the first history begins without banks. People make all payments using tangible paper fiat currency.

Because of fear of theft, a business opportunity exists. Money is fungible, so there is no need to have individual safety deposit boxes. The bank, or "money warehouse," as Murray Rothbard calls it, opens up and begins taking deposits. Accounts are kept for each depositor and the funds are stored in the safe. Depositors can claim their money that they have stored at the bank at any time.

The banks charge people a monthly storage fee. The nominal interest rate on these bank deposits is slightly negative, reflecting storage costs.

In order to make ordinary payments, people still have to keep currency at the home, leaving them targets for burglary and worse, home invasion and robbery. And they must carry currency to actually make purchases.

This creates a further business opportunity. The banks begin to allow payments by check or electronic equivalent.

Because retailers want the business of customers, they accept checks drawn on all banks in payment. Because banks want the business of retailers, they accept checks drawn on all banks for deposits.

The banks organize a clearinghouse to settle net clearing balances. Each bank initially deposits currency at the clearinghouse. As a bank receives checks drawn on other banks for deposit by its customers, it in turn deposits those checks at the clearinghouse. The clearinghouse adds the funds to the clearing account of the bank making the deposit and debits the balances of the banks against whose customers the deposited checks were drawn.

The electronic payments system signals a shift in those clearinghouse balances between banks, reducing the balance of the buyer's bank and adding to the balance of the seller's bank. Then the buyer's bank decreases the buyer's account. And the seller's bank increases the seller's account. All of these payments operations are costly, and so, presumably they are covered by fees for each check or electronic payment.

The money that has been deposited into each bank is matched by that bank's reserves. Some of those reserves are held as vault cash and some is held as a balance at the clearinghouse. The funds banks have deposited at the clearinghouse is matched by the clearinghouse's vault cash.

This scenario is central to understanding the concept of "Fractional Reserve Banking." Of course the amount of reserves these "banks" hold is a variety of fractions of various things, but the key fraction is that reserves are equal to 100 percent of deposits. Because 100 percent is greater than or equal to one, this is not fractional reserve banking.

This account of banks is still very thin. There has been no discussion of bank capital. There has been no discussion of bank leverage. There has been no discussion of bank profit or loss. Presumably, those organizing these peculiar banks would need funds to purchase the building, the vault, and so on. The owners could put up money--equity. And the bank could sell bonds, and fund some of its operations by debt. The capital ratio would be capital divided by assets and leverage would be debt divided by equity.

If the funds deposited are treated as being owned by the depositors (and how that works with some reserves deposited at the clearinghouse is a bit of a puzzle,) then reserves are not bank assets and deposits are not bank liabilities.

Of course, if the bank is robbed, it is possible that it would just apologize to the depositors and say that it was unsuccessful in guarding their funds. Or, perhaps it would have to use the bank's remaining assets to make good on the deposits as best it can--selling the vault and the building. If that is the situation, then the deposits are liabilities of the bank and reserves are assets. The result would be a much thinner capital ratio and much higher leverage than otherwise.

The bank's profits would be the difference between revenue, storage and payments fees, and costs, depreciation on the building and equipment, employees, and the like. If the bank earned profit, its capital would increase and its leverage decrease. If those profits were paid out to the owners, then the capital and leverage would remain the same. Losses, on the other hand, would reduce capital and raise leverage. If losses persist, the institution could fail. It is possible that it would not be able to pay off all of its creditors. For example, those who helped finance the "bank" by purchasing bonds.

Of course, there are other creditors as well--the depositors. They could also share in the losses if the bank failed. A robbery, fire, or other disaster destroying the bank's reserves would be one source of losses, but if the collected fees were too low to cover costs that would also create losses.

Implicit in this model is generally an assumption that deposits are senior to other sorts of debt, and that a bank must be closed down before it touches the "reserves" that "back" the deposits, and pay all of them off. Presumably, this is due to imagining that the depositors own the funds in the bank's vault and on deposit at the clearinghouse and ignoring what happens with theft or natural disaster.

What then, is fractional reserve banking? Rather than store all of the depositors' funds and holding a "reserve" equal to deposits, the bank lends some or all of those funds out.

Starting from a baseline in which banks store deposited funds, any remaining reserves are divided by the amount of deposits. The resulting "fraction" is less than one. "Fractional Reserve Banking" then, starts with a narrative of banks storing money for depositors, thus keeping 100% reserves for those depositors. "Fractional Reserve Banking" is a deviation from that ideal, with banks lending out some of the money, and the "fraction" then, being less than one.

Critics of fractional reserve banking sometimes allege that this is inherently dishonest because the bank is lending out the depositors' money rather than storing it. Or, the critics worry about the possibility of a bank run--that is, the depositors seek to withdrawal their money, and there are insufficient reserves to pay them all off on demand because some of the money remains outstanding. However, nearly always, critics of fractional reserve banking are more worried about the macroeconomic implications of the system. In particular, the impact of fractional reserve banking on the quantity of money and the price level.

With 100 percent reserve banking, the quantity of money is equal to the quantity of tangible hand-to-hand currency. It is possible to divide that into the currency held by the nonbanking public and their deposits in the bank. From the point of view of ordinary households and firms, they have currency that they can use to make payments and they have "deposits" at the bank which they can use to make payments. But since the banks "back" the deposits with currency reserves, either held in their own vaults or in the vault of the clearinghouse, the total amount of money is unchanged whether it is in the bank or out of the bank.

Now, suppose one of those banks makes its first loan. It puts currency in a suitcase and delivers it to a borrower. Immediately, the borrower has the currency. But the depositor still has the money in his or her deposit account. The total quantity of paper currency is unchanged, but both the depositors at the bank and the borrower are using it some of it. This situation is considered inherently fraudulent by some critics of fractional reserve banking. In their view, the two people "own" the same money, which is impossible.

Regardless of this "ownership" issue, money can no longer simply be identified with the quantity of paper currency. The quantity of paper currency held by the nonbanking public--households and firms including the borrower, plus the total of bank deposits held by the nonbanking public is the quantity of money. Since the depositors at the bank still have an unchanged quantity of deposits, and the borrower now has some of the currency that was held at the bank, the loan has increased the quantity of money.

Since banks have access to the payments system, they don't need to make loans by paying out currency. A more reasonable and realistic scenario is for a bank to make a loan by creating a deposit for the borrower. The borrower can then spend the loan by writing checks or making electronic payments.

The impact on the quantity of money is the same. All of the depositors still have their deposits, there is also no change in the currency held outside the banking system that remains in the hands of households and other businesses, but now the borrower has a new deposit. This is new money created by the bank. The total quantity of money increases exactly as before--increased by the amount of the loans.

Rather than some strained interpretation where the "real" money, the currency, is somehow doing double-duty and two people "own" it at the same time, this more realistic scenario points to the real situation, the banking system has created new money. If, for some reason, a bank did lend out currency, then the bank has created an equivalent portion of the deposits.

Why is the creation of money by bank a problem? It is because an increase in the quantity of money, ceteris paribus, reduces the purchasing power of money. This means, ceteris paribus, the money prices of goods and services rise. All of those who were holding money will, in the end, have a smaller command over goods and services.

Ceteris paribus means "other things begin equal," and perhaps the most important thing that must be equal is the demand for money, the amount of money people choose to hold. If a bank were to create money, and at the same time, the demand for money had risen the exact same amount, then the purchasing power of money and so, the prices of goods and services would remain unchanged.

However, many critics of fractional reserve banking would correctly point out that the increase in the quantity of money created by banks results in the purchasing power of money being lower than it would have been regardless of what is happening to the demand for money. And if the demand for money happened to be rising as least as much as the bank-instigated increase in the quantity of money, then those holding money are robbed of their rightful real gain from money holdings.

So, money creation by banks creates a problem. And they create this problem by lending out reserves. If the banks don't create the problem, and simply hold the reserves, then they have a 100 percent reserve ratio. There is a currency reserve backing 100% of the deposits. The reserves are 100 percent of deposits. The smaller the fraction (less than one) that banks keep, the greater the problem that banks are creating. So, banks that keep 90 percent reserves create a small problem. Banks that keep 10 percent reserves, create a bigger problem.

Understanding patterns that are the unintended consequence of individual action is the key subject matter of economic science. Economists have long understood that "money warehouses" that start to create money by lending reserves interact in a way that has the unintended consequence of "multiplying" their efforts.

For example, if an individual bank keeps a 50 percent reserve, then it would appear that it would increase the quantity of money by 50 percent of the amount of initial deposits. If all the banks do this, then the total quantity of money should be increased by the banking system by 50 percent of the deposits.

However, this is a fallacy of composition. If banks created money for borrowers, and they simply held it, then this would be true. However, borrowers generally spend what they borrow, and those selling to the borrowers typically deposit the funds they receive in some bank, which creates new deposits for banks to lend out.

If there are more than a handful of banks, any one bank that creates a deposit for a borrower, must expect that the borrower will soon spend the funds. Those selling to the borrower will deposit the funds in other banks. The other banks will deposit the sellers' checks at the clearinghouse, and the clearinghouse will debit the banks' balance there. The individual bank gives up reserves when it makes a loan. With electronic payments, the borrowers payment signals the clearinghouse to decrease the reserve balance of the bank making the loan and increase the reserve balance of the seller's bank--the bank whose customer is selling goods or services to the borrower.

If these sellers' banks keep 100 percent reserves, nothing more happens. But if they habitually lend out part of their reserves, then it is likely that they will respond to the increased deposits by their customers who received payment for added sales, by expanding their lending as well.

If all banks keep the same fraction of reserves to deposits, then very simple algebra can be used to find a deposit multiplier, which is ratio of deposits to reserves (D/R). It is simply 1/r, where r is the reserve ratio.

So, if banks keep 80 percent reserves, and lend out 20 percent of their deposits, then the multiplier will be 1/.8 or 1.25. While each bank directly creates money equal to 20 percent of deposits, their interaction creates 25% additional deposits.

While that isn't too significant of a difference, consider a 50% reserve ratio. Then the multiplier for deposits is 1/.5 or 2. While each bank directly creates new money by making making loans with newly created deposits equal to 1/2 of its existing deposits, which would suggest a new level 1.5 times the initial level, the interactions of the banking system doubles the amount of deposits.

With a 10 percent reserve ratio (the legal minimum in the U.S. today,) then this simple multiplier is 1/.1 = 10. While each bank creates new money equal to 90% of its deposits, suggesting they would slightly less than double the amount of money, the increase is tenfold!

Of course, the problem created by fractional reserve banking is the creation of new money, and deposit money is only one type of money. Given the "power" of thinking about simple ratios, many economists have suggested that perhaps the amount of currency that firms and households keep outside of the banks is a simple ratio of the amount the keep in the banks. In other words, the proportions of currency and deposits people keep remains constant as the total quantity of money, currency plus deposits, change.

Assuming that the currency/deposit ratio remains constant, simple algebra shows that the money multiplier, the ratio of both deposits and currency held by firms and households to the total amount of currency plus bank reserves is equal to (1+c)/(c+r), where c is the ratio of currency to deposits and r is the ratio of reserves to deposits.

If the banks keep 100% reserves, then r equals one, so (1+c)/(c+1) = 1. The total amount of money is equal to the currency held by the public plus the reserves of the banks. In the scenario here, that would be their vault cash plus the currency they have deposited at the clearinghouse. The total quantity of money would equal the total quantity of paper currency. By keeping 100 percent reserves, the banks have no impact on the total quantity of money. Other things being equal, they are not creating new money and causing inflation.

Suppose, instead, that households and firms keep $8 of currency for every $10 of deposits, and banks keep a 10 percent reserve. The money multiplier is (1+.8)/(.8+.1) or 1.8/.9 or 2. The result is that the banking system doubles the quantity of money. Other things being equal, fractional reserve banking would half the purchasing power of money and double the price level!

If one imagines going from 100 percent reserves to 10 percent reserves with a step by step process over time, then banks are making loans, and receiving deposits and making new loans. As this expands the total quantity of money (and spending and prices) there is a greater demand for currency and so some currency is withdrawn from the banks and held directly, but most is deposited and lent again. This process looks suspiciously like some kind of "credit bubble," that is liable to burst!

Most concerned about instability of fractional reserve banking are concerned about changes in the money multiplier. If banks keep 100 percent reserves, the money multiplier is one. It is also one if no one keeps any money in banks. The formula is a bit awkward for that scenario, because as people hold more currency and less deposits the ratio grows progressively larger. Unfortunately, when deposits equal zero, then it becomes undefined. However, using limits, (c+1)/(c+r), approaches one as c approaches infinity. So, if no one uses banks, then the quantity of money is again equal to the amount of paper currency. (Of course, that is obvious without appealing to the equation or limits. No banks, and no impact of banking on the quantity of money.)

And so, the story would be that when times are good, people trust banks and the currency deposit ratio falls. Further, banks seeing strong prospects for loans and having little reason to worry that their depositors will pull out their money, they reduce their reserve ratio. With the reserve ratio less than one, (c+1)/(c+r) rises with a lower value for c. More currency is put into the banks, and so, more money created by the banks. With r in the denominator, a lower reserve ratio also results in the banks creating more money. And, of course, the additional money created by the banks is matched by increased lending.

In bad times, everything goes into reverse. The banks, worried about bad loans, may reduce lending and increase reserve ratios. Depositors, worried about their banks failing, withdraw currency, raising the currency deposit ratio. Banks, worried that their depositors might withdraw currency, raise their reserve ratios to have vault cash to pay out. Worse still, since banks only have fractional reserves, and are generally obligated to pay off depositors on demand as long as they have reserves, they may face runs. Depositors, worried about bank losses may try to withdraw money first, before the bank runs out of reserves. All of these various worrisome processes reduce the money multiplier and cause the quantity of money to fall.

The conjectural history by which banks began has money warehouses and then began to lend out part of the money they stored, makes "Fractional Reserves" an important aspect of banking. That banks keep "fractional" rather than 100 percent reserves gives them special macroeconomic import, and changes in the exact fraction of reserves banks hold determine the size of that macroeconomic import.

Does this account of banking make sense in the context of the other conjectural history of banking? Suppose banks begin as financial intermediaries, borrowing money and then lending that money out. Can such banks borrow by issuing monetary instruments? Are fractional reserves and a multiplication processes a useful way to describe the operations of such a system? Those issues will be explored in Fractional Reserve Banking 2.